NOBEL PRIZE WINNER: This Is The Difference Between Thinking Fast And Slow

When advisors want to understand why their clients make seemingly
irrational financial choices, odds are they will find answers in
the research of Nobel-winning behavioral economist Daniel
Kahneman. But guiding clients toward a better financial
future is only one way to apply behavioral finance. Kahneman says
we solve virtually all problems, not just financial ones, with
two distinct types of thinking.

His recent book, Thinking, Fast and Slow, was a
2011 bestseller. It summarizes his lifetime of work on how
the mind works, covering many topics familiar to those who follow
behavioral economics and finance: prospect theory,
overconfidence, loss aversion, anchoring, separate mental
accounting, the representativeness bias and the availability
bias.

Kahneman, who, at 82, is still teaching at Princeton, recently
discussed these and other discoveries at the 2012 CFA Institute
Annual Conference, which took place in Chicago on May 6-9.

I’ll look at how Kahneman’s research can be applied in the
context of investing, but first let’s examine the central subject
of his book: our two ways of thinking.

Think fast! Or think slowly?

Try this experiment: Just before making a left turn in a busy
intersection, begin to multiply 17 by 24. I’m kidding; please
don’t. You’ll either quickly abandon the arithmetic problem or
wreck your car. But I’ll bet you can add two plus two while
making a left turn without any problem whatsoever.

What is the difference between the two tasks?

Most people would say that one of the tasks is easy and the other
is hard. But Kahneman, who won the 2002 Nobel Prize in
economics for work relating economic decision-making to
psychology, says that there’s more to it – a substantive
difference, not merely one of degree.

Adding two and two is done using what Kahneman calls System 1
thinking, the kind of fast thinking that feels like it is done on
autopilot. The product of 17 and 24 is arrived at using
System 2 thinking – slow, deliberate thinking that involves an
entirely different physiological process, one that (for example)
interferes with driving a car.

When you engage in intense System 2 thinking, Kahneman says,
something happens to your body. Your pupils dilate.
Your heart rate increases. Your blood glucose level
drops. You become irritable if someone or something
interrupts your focus. You become partially deaf and
partially blind to stimuli that ordinarily command your
attention. Kahneman writes that “intense focusing on a task
can make people effectively blind.”

My grown son recently reported an occurrence of a related
phenomenon, blindness caused by having made up one’s mind.
While he was preparing to perform in a concert, his girlfriend
paid him a surprise visit, hundreds of miles from either his home
or hers. Despite increasing efforts to recognize the
strangely familiar person approaching him from a distance, he
couldn’t figure out who she was until she was quite close.
There is nothing wrong with my son’s eyesight. Having
decided, using System 1 thinking, that his girlfriend was far
away, it was physically impossible for him to see her until she
was right under his nose. He was unable to invoke System 2
thinking to figure out that maybe she had taken an unplanned
trip. He was temporarily blinded by an idea.

A young boy’s puzzlement about human nature

Kahneman, a World War II-era refugee from Germany, recalls that
he first became interested in psychology when, as a young child,
a German police officer asked to talk to him. Rightly
terrified of the officer, young Danny Kahneman, a Jew, discovered
that the officer was interested in him because he reminded the
officer of his own son, who had died. The officer became
very emotional when conversing with Danny, gave him money, and
kept him safe.

From that point forward, Danny decided to figure out what made
people tick.

Thinking, Fast and Slow reads like a primer,
romping through familiar territory, but that is because Kahneman
was instrumental in discovering much of what he discusses.
Younger scholars such as Richard Thaler, Shlomo Benartzi, Hersh
Shefrin, and Meir Statman may have gotten to the reader first,
but Kahneman and his deceased collaborator, Amos Tversky, are the
true source of most of these insights.

Systems 1 and 2 in focus

The phrase “what you see is all there is,” a play on the old
adage “what you see is what you get,” runs through the book like
a mantra to describe System 1 thinking. System 1 takes
visible evidence as the only source of knowledge, and ignores
hidden evidence. Centered in the brain’s amygdala (a part
of the limbic system or “reptile brain”), System 1 evolved in
response to the need to obtain quick answers. Over here is
a tiger: danger! Over there is a pheasant: delicious!
Those who needed to think slowly and carefully to arrive at these
conclusions did not survive to become our ancestors.

System 2 is more complex, and resides in the brain’s prefrontal
lobes, which are well developed in humans but not in other
animals. System 2 recognizes that what you see is not all
there is. Is Steve, “a meek and tidy soul, with a need for
order and structure, and a passion for detail” a businessman or a
librarian? While System 1, spotting the resemblance between
the description and the librarian stereotype, shouts out
“librarian,” System 2 recognizes that the number of librarians,
relative to businessmen, is tiny and that Steve is actually more
likely to be a businessman, despite personality traits that might
have made library work a better fit.

In Kahneman’s telling, System 2 clearly produces the superior
answers, at least in most situations. A great deal
of Thinking, Fast and Slow is devoted to
demonstrating, through psychological experiments, how System 1
gets it wrong. “How many animals of each kind did Moses
take into the Ark?” “Two,” says System 1. “You’re
trying to fool me,” says System 2. “It was Noah.”

These two conflicting brain functions behave differently in
noteworthy ways. System 1 doesn’t mind working all the
time, for example, because its work is not that hard. When
System 2 is put to work, it requires so much effort that it takes
over the whole body, so it goes to work only reluctantly.
People do not shy away from solving problems requiring a quick,
automatic reaction but, perhaps because they anticipate the
physical strain described earlier, they procrastinate in working
on questions that require careful thought. No wonder young
kids hate word problems in math class: word problems test the
ability to puzzle out what math problem the questioner wants
solved, a task much harder than doing the underlying
arithmetic.

Malcolm Gladwell’s beautifully
written Blink is essentially an argument that
System 1 thinking produces the superior answers. When Kahneman
catalogs the errors of System 1 thinking, some laughable and some
tragic, it becomes obvious that Gladwell’s celebration of snap
judgment is terribly flawed. I am being a bit unfair to
Gladwell because he does expend some effort identifying when
quick thinking goes awry. But his antagonist, David Adler,
whose book, Snap Judgment, is a response to
Gladwell, makes the far better case that judgments rendered in
the blink of an eye are usually wrong, and that it is necessary
to apply System 2 thinking if one is serious about coming to
sensible answers to most questions.